Great challenge for Indian banks: How to manage capital by taking optimum risk

Great challenge for Indian banks: How to manage capital by taking optimum risk

With expected higher growth of GDP, the credit growth in India is expected to pick up in the coming years mainly due to higher requirement of credit to infrastructure sector and government’s drive on financial inclusion.

With expected higher growth of GDP, the credit growth in India is expected to pick up in the coming years mainly due to higher requirement of credit to infrastructure sector and government’s drive on financial inclusion. (Source: PTI)

Basel II was an important risk management framework before the financial crisis of 2008-2009. After the crisis, the approach of Basel II which was considered as more risk sensitive as compared to Basel I, was found wanting. Some of the major causes of the global financial crisis were: too much leverage, too little capital, and inadequate liquidity buffers with complicated derivative products. Other factors also responsible for this crisis were: shortcomings in risk management, corporate governance, market transparency and quality of supervision. These have pinpointed the systemic loopholes in Basel II framework. Basel III was an outcome to address the weakness of the past crisis and to make the banking sector stronger and efficient enough to face any crisis. The major thrust area of Basel III is improvement of quantity and quality of capital base of the banks with stronger supervision, risk management and disclosure standards.

With expected higher growth of GDP, the credit growth in India is expected to pick up in the coming years mainly due to higher requirement of credit to infrastructure sector and government’s drive on financial inclusion. With the expected higher demand for credit growth along with implementation of new Basel III framework, banks need to have higher capital requirements. As a result of this, cost of capital of the bank will go up. This is because to meet the new norms, apart from government support a significant number of banks have to raise capital from the market. This will push the interest rate up, and in turn, cost of capital will rise while return on equity (RoE) will come down. To compensate the RoE loss, banks may increase their lending rates.

However, this will adversely affect the effective demand for loan and, thereby, interest income, which may in turn affect the profitability of banks. Further, with effective cost of capital rising, the relative immobility displayed by Indian banks with respect to raising fresh capital is also likely to directly affect credit offtake in the long run. All these will affect the profitability of banks. Considering the current high level of NPAs along with poor operating profits, the requirement of capital will be much more mainly in PSBs. Banks which are incurring losses or having very low profit margin, will be affected most because they will require more capital as conversion from profit to capital will be less. This will pose a great challenge to PSBs on how to manage their capital, where capital is scarce and costly. Thus, for maintaining a healthy capital adequacy ratio through optmisation of capital, banks needs to make an extra effort in the following five areas.

i. Change their business models and business strategies from corporate (except in the case of clients who are A rated and above) to more retail customers as retail requires less capital. Further, in corporate banking, as chances of a default in short-term loans is less, on an average, compared to chances of a default in long-term loans, banks need to shift towards short-term/retail loans.

ii. Change their facility from long-term lending to short-term lending, i.e., mainly cash credit facility, as this requires comparatively less capital. Further granting more short-term loan will also help the banks to manage their asset liability mis-match more effectively and thereby may help to reduce its liquidity risk and interest rate risk in banking book.

iii. Implementation of robust MIS and good quality of data. Banks must improve systems and procedures, refining their rating model/data-cleaning/ modernisation of systems and procedures may help banks economise their risk-weighted assets, which will help reduce capital requirements to some extent.

iv. Framing of sophisticated risk models for estimating major risks correctly, setting up an enterprise-wise risk management system, which not only aggregates all types of risk in the bank in a single platform but also helps to save capital through diversification benefit for capital computation where various risks are negatively correlated

v. Banks need to review their capital allocation to each client segment and price it in line with the profile to ensure that capital is allocated to segments that generate higher risk-adjusted returns.

It is interesting to note that though risk capital may be the necessary safety cushion for banks, capital alone may not be sufficient to protect them from any extreme unexpected loss events. In reality, risk capital will remain only a number and may not be effective if banks do not assess their risk periodically and take timely corrective action when the risk exceeds the threshold limit. Thus, whether it is Basel II or Basel III, it is crucial that a bank does not depend solely on “regulatory capital”. What is needed in a dynamic world, where all risks are interrelated with each other, a robust integrated risk management system in a bank, which includes integration of various risks, integration of risk transfer and integration of business processes, which lead to increased organisational effectiveness, better risk reporting, and improved business performance, respectively.

Improved business performance again depends upon how much risk one takes. It is interesting to note that banks need to take an optimal amount of risk based on its risk appetite, in order to maximise its shareholder value. If a bank takes too little risk compared to its optimal level, it may not generate sufficient returns for its shareholders, which could decrease the value of the bank. Alternatively taking on too much risk may also decrease the value of a bank. Thus managing capital through taking optimum level of risk is a great challenge to Indian banks.

To address this challenge, a new approach is required, where “risk” should not be considered as value destroyer to the organisation, rather “risk” should be considered as a potential source of new return, where the robust risk management system may help maximise the value of a bank. To maximise the value of a bank, it is the “Risk Adjusted Return”, which needs to be maximised through informed decision making, proper selection of clients with its business, updating employee skill set, appropriate risk mitigation systems and polices, taking adequate amount of quality collateral security, better operational control and finally appropriate risk pricing. In order to do this, there is a need for framing a new risk culture across the bank, where minimisation of risk is not the responsibility of risk management department alone. As every employee is an asset and also is a potential source of risk, in an organisation, it is the responsibility of each employee, to act as a risk manager to mitigate its risk. This will not only help the bank to mitigate the risk in a much more pragmatic way but also will enable the bank to maximise its risk adjusted return in a more effective manner, thereby, increasing the shareholders’ value.